After nearly 20 years of investing experience I cannot think of anything more important to consider for your investment strategy. I have a large library of books I have read and re-read, but one central theme appears again and again since the beginning of time, "Downside Investment Risk". As it appears that we are once again on the edge of another Bear Market it moves me to write about the simplicity of avoiding the "Impact of Losses" on investment portfolio values. Below is a graph produced/shown many times and in many different ways over the years, but the numbers are still the numbers that tell a story.
How to read this chart above is rather simple. If you lose 20% of your portfolio value it will take 25% future investment growth to get your investment portfolio back to even. What becomes alarming is to notice the larger increase requirements for growth percentage amounts for every additional 10% decline. A quite common possible scenario now days is a portfolio losing 60% of its value during a bear market. So if you have $1,000,000 starting value you would only have $400,000 after a 60% decline. That means that you will have to get a total return of 150% over the next few years to get from $400,000 back to $1,000,000.
So how long will that take to recover a 60% portfolio value reduction? Well, that depends on what you invest in, but let's say for the purposes of most individuals we just stay invested in the overall market. The average return many analysts and academicians often state can very from 5% to 11%. I think that number is probably a lot closer to the 5%, but for this purpose lets just say its 8%. So if we compound the $400,000 by 8% per year it would take us nearly twelve years to recover a 60% loss. That is also assuming that there are no years in between less than 8%.
Twelve years is a long time to wait!
Now lets take another angle at this theme of market losses. When I started my investment career in 1999 during the time of Y2k panic and technology market euphoria I was shown a chart of why clients should always be in the market. It said that if you missed the top 10 best days of the market your returns would largely under-perform the market. It was meant to encourage investors to stop trying to time the market. But after a number of years of trading I learned that the biggest obstacle to good investment returns is protecting against the downside returns. If anyone has ever attempted to learn trading they will almost certainly stumble into the teaching of keeping your losses short for the very reason shown above. But what made the following graph below so fascinating to me a number of years ago was looking at avoiding the top 25 worst days of the market.
*Chart Borrowed from The Irrelevant Investor.com
Clearly, as shown in the graph above, the strategy of investment returns is to develop better defenses and focus less on the best 25 days. You can see that missing the top 25 best days does impact the investment returns but not nearly the impact that losses take on a portfolio.
Again as I think of the coming Bear Market I would encourage you to make sure you are comfortable with the strategy you have either accepted or developed. Based on just the concept above the strategy should have a part of defensiveness. If not, well then time is of essence and now is the time to make sure you have a great strategy. Both the February and Octobers sharp market losses should be a wake up call that the investment environment is changing.
Your comments and thoughts are welcome…
John Hamel is the Managing Member of Austec Wealth Management, LLC. helping current & retired business owners optimize relative to their company value and personal life.